by Scott Kupor
Other times, we have what is called a recapitalization of the company (led by either a new investor or existing investors). A recapitalization not only often includes a much lower valuation than the company has previously raised at but also can include reductions in the liquidation preference and even reverse splits of the stock to reduce the equity ownership of existing investors.
We Are Where We Are, and Something Needs to Change
These difficult situations can, unfortunately, often be a part of the entrepreneurial process. Understandably so, founders oftentimes try to maintain a smiling face and look for other ways to finance the business. We’ve seen this many times at a16z. When the going gets tough, nobody starts the conversation with a recapitalization proposal; rather, the entrepreneur or the board often thinks first about providing what’s called a bridge financing. Generally that means a cash infusion from the existing investors in the form of a convertible note or as an extension to the last round of financing (basically, just reopening the last round and having existing investors invest on those terms).
While each of these can seem like the easier path, they are often the wrong way to proceed because they don’t really solve the underlying problem: for a variety of reasons, the business just did not develop the way in which the board and the founder had originally planned.
Perhaps the market developed more slowly than anticipated, the initial product missed the mark, thus causing the company to be in market with the correct product later than anticipated, the sales engine didn’t materialize as expected, or the management team took too long to hire and get functional. Whatever the cause, it’s smart to take a hard look at reality and say, “We are where we are, and something needs to change.”
In nearly all these cases, the company has probably grown expenses beyond the level that it can rationally support at this stage. That’s understandable in that the hiring plan anticipated a set of milestones that now appear further out than originally contemplated. As a result, kicking the can down the road by not taking the hard actions required to get the company back on a solid footing—including addressing the current cost structure alongside addressing the right capitalization structure—generally does not work.
What a down round or recapitalization does, when properly executed, is to reset the company and allow it to restart the journey toward success. It’s painful, no doubt, for both the company and the existing investors, but if everyone still believes in the mission, this is the most likely path to success.
In the absence of doing so, the company may continue to move forward but is likely to face another challenge when seeking to raise its next round of financing. For when the time comes to raise additional capital, the new downstream investor is likely to feel that both the company valuation and the amount of liquidation preference are beyond the actual state of the business. And nothing can be more damaging to a business than having to reset once again after it is just starting to regain some of its momentum.
It is entirely possible to emerge successfully from a down round, but it is also entirely possible that, despite everyone’s best efforts, the CEO and the board don’t believe there is a viable path forward for the business and there are no acquisition alternatives. Sometimes the only remaining path is to wind down the company.
But let’s not go there quite yet. Let’s look first at other options. Remember, “Live to fight another day” is sometimes the right answer.
Reducing Liquidation Preferences
Let’s talk first about the reduction or elimination of liquidation preferences.
We talked earlier about the auto-convert in a term sheet. This is the provision that governs the circumstances under which the preferred stock can be converted into common stock—either voluntarily or automatically. In the voluntary category, we noted that often the term sheet defines some level of voting threshold from either the capital “P” Preferred or the different series of preferred stock that are required to convert preferred shares into common. Among other things, the main reason to do this is to eliminate the liquidation preferences that the existing preferred has accumulated.
It may seem odd that VCs would ever voluntarily do this, but in the case where they believe in the prospects for the business but realize that the overhang of the current liquidation preferences may disincent the current employee team or make it unpalatable for a new investor to put money into the company, the potential for upside from their equity holdings may entice them to forgo their current preference.
In some cases, VCs will create an incentive for other existing investors to participate in the recapitalization by offering a mechanism called a “pull-up.” There are lots of flavors of pull-ups, but the basic idea is to give a participating VC credit for the new dollars she is putting into the company by allowing her to pull up some of her old liquidation preference into the go-forward capitalization. In other words, instead of wiping out 100 percent of her liquidation preference, she can carry forward some portion of it as an inducement to invest in the new financing round.
In really difficult situations, the VCs may also agree to a reverse split of their existing stock holdings. That is, they convert their existing preferred into common, and then their ownership in the company is reduced by reverse splitting (maybe by as much as 10 to 1) their existing stock into an ownership percentage that is a fraction of what they own. Why would they do that? Well, similar to the liquidation preference situation, the VCs may want to give the company (and its employees) a fresh start by reducing the dilution they face in the wake of a new influx of capital at a low valuation and to attract outside capital into the company. This of course is a pretty extreme measure to undertake, so it does not happen very often.
As you might imagine, in situations like the ones we are discussing, it is often difficult to bring new, outside money into the company. As a result, down-round financings or recapitalizations, if they happen, are more often led by the existing VCs in the company.
This raises lots of the same fiduciary duty questions that we saw in the troubled M&A situation. The scenario tends to unfold as follows: the company is in trouble; there are no outside investors who want to inject capital into the business; the existing VCs decide that they want to give the company another shot but want to invest at a low valuation that reflects the true state of the company; and five years later the company turns out to be a smashing success and then the VCs (and the rest of the board) find themselves at the wrong end of a lawsuit from a disenfranchised, heavily diluted common shareholder who wants to challenge the validity of the original recapitalization. No good deed goes unpunished.
Learning from the Bloodhound Case
To prove to you that I don’t just make this stuff up, let’s look at one case in particular that highlights these issues. I decided on this one because it has such a great name—Carsanaro v. Bloodhound Technologies (let’s call it Bloodhound for short).
Here are the facts.
The plaintiffs in this case are founders and early employees of a health-care company that goes through various rounds of financing, some of them led by existing VC investors. As is often the case, the company has a bit of a troubled history, but the existing investors keep funding the company, and somehow the company pulls through and ultimately gets sold for $82.5 million.
At first blush, that sounds like a decent outcome, but when you look beyond the surface, you see that our plaintiffs get only $36,000 from this acquisition (the common shareholders as a group got less than $100,000). The rest of the money went mostly to the preferred to satisfy their liquidation preference and to a $15 million MIP. Not surprisingly, the plaintiffs sue the company and the board, alleging that the various dilutive financings that happened along the way violated the board’s fiduciary duties to the common shareholders.
As did the court in Trados, the Bloodhound court analyzed the various board members to determine whether the majority of the board was conflicted or d
isinterested. As we saw before, the VC directors who also participated in many of the inside financings were deemed to be conflicted. And in two of the inside financings, the then-sitting CEO was awarded a significant option grant contemporaneous with the financings.
On the one hand, this doesn’t seem too crazy; the CEO is going to be heavily diluted by the down-round financing, so it’s not unusual for the VCs to want to reincent the CEO by giving him more options. On the other hand, the proximity of the option grant to the approval of the financing round raises questions about the independence of the CEO board member. And that’s what the court was bothered by: there was at least an appearance that the board member’s vote was essentially bought in exchange for the option grant. Those optics aren’t good.
Having concluded that a majority of the board was conflicted, the Bloodhound court then proceeded to evaluate the transaction under the two-pronged entire fairness standard—fair process and fair price.
The court was not happy with the process. Among the things the court cited were that
the board failed to do a market check—meaning that they agreed on the terms for the insider-led financings without having really canvassed outside investors to see if they were interested in bidding for the deal;
the board needed the consent of a majority of the common stock to approve the financings, yet engaged in some shenanigans to fudge this. In one case, the board didn’t provide full information on the transaction to a key common shareholder and, more generally, the board didn’t provide full disclosure of certain elements of the transaction to other common shareholders;
the board failed to update the terms of the financing transactions in light of improved company financial performance; and
the terms were not approved by a majority of the disinterested board members.
So what should we take away from Bloodhound as it relates to the proper process a board could go through in a down round or recapitalization situation? Below are a few things to keep in mind:
It’s really important to do a market check and run a full process with outside investors. You may think that no one else will ever touch the financing given the company’s performance to date, but best practices suggest that you need to canvass your options. It’s a good thing to get noes from a lot of potential investors before you proceed with an inside-led round. This shows that you were not trying to hoard the opportunity for yourself but rather reacting to a true lack of market interest. If you can hire a banker to run this process, even better.
Be careful not to entangle new option grants to employees too closely with the inside financing. It’s customary to want to reincent the team, but doing so after the financing closes (versus before) and employing a compensation consultant to gauge the size of an appropriate grant would help eliminate any suspicion that an executive board member’s vote was contingent upon her receiving a new option grant.
Give other investors (and particularly major common shareholders) the opportunity to participate in the deal. We call this a rights offering, and the basic idea is to give everyone on the capitalization table the right to participate pro rata in the deal on the same terms. You’ll find in practice that most people will turn down this offer, but the fact of offering it to them is a very good prophylactic against future litigation.
Implement a go-shop provision in the insider financing round. Recall that we talked about no-shops in chapter 10. A no-shop prohibits the company from taking your term sheet and showing it to others to induce them to potentially bid with better terms. A go-shop is exactly the opposite. It specifically allows the company to shop your term sheet to other potential investors and is often used in insider-led rounds. This is the proactive version of a market check. Give the company the proposed terms and let them see if any outsider is willing to match or beat those terms.
As was the case in the acquisition context, to the extent you can get approval of the deal from a majority of the disinterested directors, or you can get approval from the disenfranchised common shareholders, these will be very helpful. Understandably, sometimes the board composition or shareholder dynamics make this impractical.
Finally, make sure the minutes of the board meetings reflect the board’s understanding of the potential conflict of an insider round and demonstrate an attempt to take into account the interest of the common shareholders. Get the company’s lawyers to reeducate board members on fiduciary duties and reflect the deliberations in the official minutes of the board meetings.
Success after a Down Round
While a down round is no doubt challenging, it’s not the end of the world! There are ways to set the company up for success, assuming you do in fact raise new capital. After all, if you are going to go through all the pain of the down round or recapitalization process, it would be a real shame to come out the other end without a clear plan for achieving success.
Naturally, one very important point of consideration should be how you and your team will be properly incented to continue maximizing the value of the business after the financing round. There are a few ways to achieve this.
First, as noted above, hopefully the existing VCs have considered some form of reduction in the total liquidation preferences. It may not be realistic for them to give up all their preferences, but many forward-looking VCs will recognize that some reduction is required to align incentives properly for the management team and employee base. There is no magic number to solve for here, but you should have a discussion with your existing VCs about the range of reasonable near-term exit valuations that the company might achieve and size the remaining liquidation preferences appropriately to give the common shareholders at least a shot at earning some return on their equity.
Second, because the issuance of new shares at a lower price will dilute the existing management and employee holdings, you may want to consider increasing the option pool and providing for new grants to the remaining employees. Oftentimes, in connection with a recapitalization, the company has to reduce its employee base (because the company may need to be rightsized for the state of the business and to achieve a lower cash consumption target). As a result, you may have some employees exiting the business with stock options that are well out of the money, meaning that the exercise price of those options substantially exceeds the current value of the shares. Most departing employees will not, therefore, choose to exercise those options, at least not at that time. If your options permit them to be exercised for years to come post-termination of an employee, they may very well remain outstanding for that amount of time. If, however, those departing employees choose not to exercise their options, they will come back into the pool and be available for the company to regrant to those employees who are part of the go-forward business. I realize of course that it’s no fun to be having these discussions about options essentially being forfeited by employees who are no longer part of the company, but this does in fact often happen in these situations.
In addition, though, it is often reasonable for the board to also increase the size of the option pool on its own to create a greater ability on the part of the company to reincent its remaining employees with new options. Recall that, as we discussed earlier, increasing the option pool is not free; it means that everyone of course has her ownership diluted in proportion to the size of the increase. But by allocating new options to the remaining employees, the company can more than offset this dilution in the form of the additional stock grant. The investors, therefore, will bear the brunt of the dilution, but again if they believe in the go-forward plan for the business, they will often agree to this as a means of properly aligning economic incentives.
A final mechanism to consider in this circumstance is the implementation of a management incentive plan (MIP). We first talked about this with Trados, and, as that case showed, there are certain legal considerations to be mindful of when considering a MIP.
Nonetheless, a MIP is often implemented in recapitalization or down-round scenarios in which a near-term sale of the business is being contemplated.
There are many ways to structure a MIP, but essentially think of the MIP as a mechanism by which the investors with liquidation preference agree to make some amount of the acquisition proceeds available first to defined employees in the company, before they take their liquidation preference. In general, the amount of a MIP ranges from 8 to 12 percent of the purchase price of the acquisition, and the beneficiaries of the MIP are agreed upon by the board. These beneficiaries are typically those employees who are most critical to getting the acquisition completed.
The other element you commonly see in a MIP is a prohibition against double-dipping. This means that, if it turns out that the acquisition price is higher than anticipated and thus the common shareholders do in fact get to participate in the acquisition proceeds, the MIP proceeds will be reduced dollar for dollar. The rationale for this is that the purpose in implementing the MIP was to incent employees who otherwise wouldn’t receive any acquisition proceeds because of the presence of the liquidation preference, so if that turns out not to be the case, we no longer need the MIP.
Operationally, the payout for a MIP follows the same payout of the acquisition proceeds. So, for example, if all the acquisition proceeds are paid out to investors immediately on closing of the transaction, the MIP proceeds will also be paid out then. If, however, some of the proceeds are withheld until a future date—we’ll talk later about this concept when we cover escrows in the mergers and acquisition section—then the MIP payout will follow accordingly. The form of payout will also be the same as that paid to other shareholders—cash, stock, or a mixture of the two.